The Need for Investment Policy Guidelines
In our view, every institutional investor should design a set of investment policy guidelines that reflect the unique circumstances of that institution. To help in the creation of these guidelines it is useful to start with an inventory of the organization’s assets and liabilities, current and expected, tangible and intangible.
An institution’s assets will include financial assets and real estate and might include a business value derived from business projections based on its financial history. Liabilities will include financial liabilities along with more intangible goals of the organization and the likelihood of achieving those goals with the assets at hand. Meeting them may require fundraising or a substantial restructuring of the business.
This inventory of assets and liabilities is then combined with the realities of the expected available returns from the financial markets and the liquidity needs of the institution to design a spending plan that balances the realistic return expectations with the spending needs. In other words, investing is not done in a vacuum; it is an integral part of managing the institution’s assets and liabilities.
Under this view, the volatility of returns as measured by the standard deviation of those returns is only one measure of risk. Another, less precise factor is the chance of not being able to follow a spending plan because of a shortfall in portfolio cash flow resulting from a permanent impairment of capital. An extreme example for a pension fund might be the failure to earn the assumed rate of return, resulting in underfunding and the inability to make the promised payments to the pensioners. Insurance companies, charitable foundations, endowments, and many tax-exempt organizations all have this problem of integrating the asset side of their balance sheet with the liability side through their development of a spending plan geared to their expectations of portfolio cash flow. This is a difficult problem in a world of pernicious inflation. In most cases, the investment manager is hired to earn the highest return possible. The investor’s assumptions about the spending plans or the liability side of the organization are not discussed with the manager—if indeed the investor focused on its cash flow requirements at all. To obtain the greatest benefit from their investment managers, institutional investors should encourage the participation of their managers in the formation of the investment policy guidelines by sharing with them not just their assets to be managed but the liabilities that must be serviced.
As part of good governance for institutions, the investment policy guidelines should be reviewed once a year, updated when appropriate and a clear record made of any changes and the reasons for these changes. We refer to this process as retaining “institutional memory” and find that many institutional investors may have no ready access to concise records of what and/or why they made the investment decisions they did five, ten or 20 years ago. This possible lack of institutional memory is, in part, the result of the relatively high turnover in investment committee membership. In my experience, most institutional investment committee members are highly intelligent, well-educated and successful individuals. However, they typically rotate off the committees every three to five years and are rarely there for even a full market cycle. In addition, these individuals are likely to have earned their credentials in a field unrelated to investments.
Thus, annual review of investment policy guidelines to determine if anything has changed, along with recording additions, withdrawals, expenses and rebalancing decisions are a critical part of the necessary records. If asset classes are added or removed the reasons for this decision and the research supporting the decision should be noted.
The recording of institutional investment decision-making creates a memory bank that guides and provides perspective for future decisions. It is the job of the investment manager not just to invest the money, but to listen, educate and inform the committee members of their fiduciary obligations in carrying out the investment policy guidelines.
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